What Is Volatility Skew?
Volatility skew (also called the volatility smile or smirk) describes the pattern where options at different strike prices have different implied volatilities. In equity markets, out-of-the-money puts typically trade at higher implied volatility than at-the-money or out-of-the-money calls. This creates a downward-sloping curve when plotting IV against strike price, known as the put skew or negative skew.
The skew exists because investors are willing to pay a premium for downside protection (puts) relative to upside speculation (calls). After the 1987 crash, the skew became a permanent feature of equity options markets. The degree of skew varies by stock, market conditions, and time to expiration, creating trading opportunities when skew levels become extreme.
Skew directly affects the pricing of every options strategy. When you sell a put spread, you are selling high-IV puts and receiving lower-IV credit. When you buy a call spread, you are buying higher-IV calls and selling lower-IV calls. Understanding skew helps you choose strategies that exploit rather than fight the IV differential.
How to Measure Volatility Skew
- 1Put-Call Skew = 38% - 25% = 13 percentage points
- 2Risk Reversal = 25% - 38% = -13% (negative = puts more expensive than calls)
- 3Put IV premium over ATM = 38% - 30% = 8 points (puts are 27% more expensive than ATM)
- 4Call IV discount to ATM = 30% - 25% = 5 points (calls are 17% cheaper than ATM)
- 5Skew is elevated, suggesting high demand for downside protection
Types of Volatility Skew
| Skew Type | Pattern | Common In | Trading Implication |
|---|---|---|---|
| Negative skew (smirk) | OTM puts > ATM > OTM calls | Equity indices, most stocks | Sell put spreads for rich premium |
| Positive skew | OTM calls > ATM > OTM puts | Commodities, biotech pre-catalyst | Sell call spreads for rich premium |
| Volatility smile | OTM puts ≈ OTM calls > ATM | Forex, near earnings | Sell strangles/condors |
| Flat skew | All strikes similar IV | Low-interest stocks | No skew-specific edge |
Skew Trading Strategies
When skew is unusually steep (high), OTM puts are very expensive relative to OTM calls. Traders can exploit this by selling put spreads to collect elevated premium or buying risk reversals (sell OTM put, buy OTM call) to get long exposure at a discount. When skew is flat or inverted, the opposite trades apply.
- Steep skew: Sell put spreads (high premium), buy call spreads (cheap), risk reversals
- Flat skew: No skew edge; focus on directional or volatility-level trades instead
- Inverted skew: Sell call spreads, buy put spreads, reverse risk reversals
- Calendar skew trades: Compare skew across expirations to find relative value
- Ratio spreads: Buy 1 ATM, sell 2 OTM (captures skew premium with defined risk using a spread)
- Jade lizard/twisted sister: Combine credit spreads with naked options to exploit skew differences
When Does Skew Change?
Skew increases during market selloffs as demand for protective puts surges. During calm, rising markets, skew tends to flatten as put demand decreases. Earnings announcements can temporarily distort skew as traders price in specific directional expectations. Merger announcements can create extreme skew in acquisition targets. Monitoring skew changes helps traders anticipate shifts in market sentiment.
How to Trade Options Skew
The simplest skew trade for retail investors is comparing the IV of the puts they sell in covered put/cash-secured put strategies to the IV of the calls they sell in covered call strategies. If put IV is significantly higher, cash-secured puts offer better income per unit of risk.